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Fed Levitating Bond Prices Same Way Zero Percent Down Levitated Home Prices

Bubbles are a popular way of describing unsustainable high prices. Stocks and bonds are at bubble levels just the way housing values were before they collapsed in the last decade.

Bond prices are as high as they can get, since interest rates are about as low as they can get. As interest rates started going down in 2008 bond prices went up.

And as interest rates stay down, the best and safest corporate use of free cash flow is to shrink the overall amount of shares, rather then making anything resembling a risky investment. So more cash and less shares in the hands of the institutions that own 80% of all U.S. stock has meant ever rising stock prices.

Up until the past four years, stock and bond prices traded in some sort of relationship to the underlying economy, to corporate earnings growth, stuff like that. All that matters now is that central banks keep buying back bonds from banks and that the banks use the newly printed money they get from the government to keep buying enough new government bonds to keep the game going.

How else can the U.S. government keep funding a $100 billion monthly deficit? Banks currently have $1.3 trillion on deposit with the Fed. Where did the banks get that $1.3 trillion? The Fed printed that money and used it to buy bank loans and bonds.

What did the banks do with that money? They gave $1.3 trillion back to the Fed. What is the Fed doing now with that cash? The Fed is now TWISTing $40 billion monthly into 10 year- mortgages. It is also printing another $40 billion per month to buy treasuries back from the banks—at a nice profit to the banks. The banks now have $40 billion more each month to fund the U.S. deficit. And all this at virtually zero interest rates!

Before 2007 the government created an artificial housing and economic bubble by encouraging home buying through a combination of 0% down payments and allowing below-market interest rate mortgages. Now to boost the markets, the Fed is giving banks newly printed money and the banks have used the money to buy newly issued government bonds. Is there a difference between the two in terms of ultimate negative effects on the economy. There is no difference as far as I can see.

The 0% down and below-market mortgage interest rates temporarily sent home prices to the moon. Home equity net of mortgages peaked in 2005 at more than $13 trillion. But then home equity values literally dropped in half by 2009. Even today, five years after the bubble burst, the value of all homes net of mortgages is $7.4 trillion, still down more than 40% from the 2005 high.

On the other hand, the bubble still hasn’t burst on stock prices, although they are trading at greater-fool prices. But the stock bubble also eventually will burst. And maybe sooner rather than later. Just as few wanted to acknowledge how housing prices were being artificially inflated by the government, today the optimists, against all logic, are hoping greater fools will keep pumping more and more money into stocks. That’s despite the fact that earnings and cash flow stopped growing sequentially since June of last year.

How does the circle jerk end? How does the bubble burst? There are two ways I can think of.

One, stock prices get so expensive that even at zero interest rates corporate America stops shrinking the float and begins selling shares big time. The second will be when the smart money abandons the dollar, causing the dollar to plummet versus gold.

I can’t say for sure, but fourth quarter results, which will start to be reported next week, could be the beginning of the end. Remember, front running 2013 higher taxes boosted fourth quarter wages and salaries, bonuses and capital gains by at least $100 billion. That has to have boosted fourth quarter results higher than expectations.

However, the real problem comes with future guidance. Over the next few weeks, business activity has to slow both sequentially and year-over-year as higher individual after-tax incomes plunge due to the taxes and current income that were recognized last year to avoid this year’s higher taxes. Therefore, probably by February I would expect to see the start of a real surge in both insider and corporate selling.

Charles Biderman is president and CEO of TrimTabs Investment Research and portfolio manager of TrimTabs Float Shrink ETF.

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